Thursday, January 15, 2009

COLUMN: We've only just begun to try to stimulate the economy

Lyrics here

Don't believe for one second that we spent up big in the lead-up to Christmas. That is, big enough to avoid a recession.

The retailers are telling us we were "healthier, guilt-free" over Christmas, spending a record $37 billion on the back of billions of dollars in government stimulus payments.

But it's an illusion. We spent only about 2 per cent more than we did the previous Christmas. Inflation ran at 5 per cent. In real terms - which is how recessions are calculated - our spending is going backwards. We are buying less than we used to. We are in a retail recession.

Would it have been worse without those millions of December bonus payment cheques, each worth $1,000 or more? Probably not much worse. In November before the cheques arrived retail spending was crawling along at 1.9 per cent per annum - about as fast as the retailers say it was afterwards...

The Treasury didn't expect much of an impact at Christmas. It's guesswork was that we would spend a mere 1 in 10 of the bonus dollars before the end of December, a further 3 this quarter and another 3 the next. Over time the economy would benefit more as some of the money was re-spent. But the net effect of pouring about $10 billion of government dollars into the economy would be about $10 billion. In economist-speak, there wouldn't be a multiplier.

The Treasury's in distinguished company. Professor John Taylor of Stanford University devised the so-called Taylor Rule used by central banks to set interest rates. He told the American Economic Association's annual meeting in San Francisco this month that neither of the Bush government's two emergency tax rebates in 2002 and 2008 had made any difference to consumer spending. The problem was that they were temporary. We adjust our spending based on what we think we are going to be earning, not on the dollars that happen to fall into our pocket on any given week.

Applied to Australia his thoughts would suggest that permanent increases in the pension are a good thing - as soon as possible, as would be the mooted permanent increase in the unemployment benefit, and perhaps, permanent tax cuts.

But the problem with permanent measures is that they are... permanent. They're a perpetual drain on government finances and they are hard to unwind when it's time to cool the economy down.

Even tax cuts appear to have less of an effect than they used to because punters have jigged to the reality that they are never permanent - they are always eaten away as inflation pushes the recipients into higher brackets.

Professor Christina Romer will be at the centre of decision making in the new Obama administration. She'll head his Council of Economic Advisors. After an exhaustive study of every major US tax change between 1947 and 2006 she concluded their effect had shrunk. But in certain circumstances they could could still pack a big punch.

Unfortunately those circumstances are different to the ones we are in today. She finds that in good times when there is no economic need for a tax cut, a uncalled for cut can boost economic activity by an extraordinary 3 times its cost. It would be as if our economy got a $30 billion kick along from the government's $10.4 billion stimulus package instead of the $10 billion the Treasury is expecting.

That's in good times. When the economy is actually tanking she finds that tax cuts don't do much - they boost the economy by less than their cost, although it's hard to be sure because it is impossible to know how far things would have tanked without the cuts. None of this is to say that tax cuts shouldn't be tried - the Obama administration is about to try them - just that the effects are uncertain and the cost is ongoing.

A more certain way to boost spending would be to promise to increase taxes. Princeton University's Alan Krueger has suggested that the US legislate for a extra consumption tax of 5 per cent to take effect in two year's time. As he says, it would encourage households "to spend money now, rather than after the tax is in place". That's what happened in Australia in the lead-up to the GST.

Infrastructure spending has a more certain effect on the economy. The best estimate suggests that each dollar spent boosts economic activity by around $1.40. But it's hard to get going quickly as the last Labor Prime Minister Keating and his Treasurer John Dawkins discovered during the early-1990's. By the time the money started flowing, the recession was ending all by itself.

And critics are worried about roads to nowhere - railways and freeways that are built merely to get money out the door rather than because they will benefit the nation. But it's a misplaced concern. There mere act of spending the money will benefit the nation. Unlike tax cuts or bonus payments infrastructure spending can't be saved and will help keep people in jobs.

Anyone who knows someone who was unfortunate enough to lose their job during the last recession will appreciate the benefits. And by allaying the fear of unemployment, all of us will feel more free to open our wallets.

The important thing is to do something quickly, probably a mix of things. So far our leaders have done nowhere near enough.

Expect announcements from next week.


Christina Romer and David Romer, The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks, November 2008

Gregory Mankiw,
Is Government Spending Too Easy an Answer?, New York Times, January 10, 2009

Brad DeLong,
The Romer View of Tax and Spending Multipliers Revisited, January 13, 2009

Greg Mankiw,
The Importance of Being Exogenous, January 12, 2009

Gary Becker,
On the Obama Stimulus Plan, January 12, 2009

Richard Posner,
The Obama "Stimulus" (Deficit Spending) Plan, January 12, 2009

6 comments:

Anonymous said...

Considering that modern employment isn't fungible, how will infrastructure projects give jobs to people most likely laid off in finance and IT?

People are looking for Keynesian solutions despite the fact that the world was very different in the 30s (mostly unskilled labour) and that there is no hard evidence that Keynes's prescriptions actually worked, aside from the post hoc ergo propter hoc fallacy.

Marek said...

Well since they are probably going to build toll roads/desal plants using some insane ppp model that no one understands(while still using our money of course) the finance and IT guys should be fine!

Anonymous said...

I don't think it is that simple Marek. Most of Australia's economy is service based. It is quite likely that the service economy will suffer a recession. Jobs are not immediately transferable from the service side of the economy to manufacturing side.

These ideas worked in the 30s because a vast majority of the labour was manual labour. A person who worked in a factory could help build a road. It is not as equivalent now, and while perhaps in desperation some might make the switch, it is unlikely that few will immediately.

Marek said...

I was having a bit of a go at how what was once simple, ie government spending money on building a road or train station etc, has been complicated.

While I generally agree with you that some area will be harder hit than others, times are different to the 30's, building a road requires much less manual labor than it once, and construction companies now have IT systems and still require financing. Someone who does financial auditing for a retailer can go into payroll at a construction company with minimal retraining.

EconoMan said...

A minor technical quibble, Peter. Rather than saying 'there wouldn't be a multiplier', an economist would say 'the multiplier is one'.

Also, as Krugman notes, you also have to consider the 'bang for your buck'. At Australia's average tax rate of around 25%, it only costs the Government a net $0.75b to deliver $1b of spending.

http://krugman.blogs.nytimes.com/2009/01/13/bang-for-the-buck-wonkish/

Anonymous said...

I don't think you've got me Marek.

First of all, even with less manual labour required for construction than the thirties, employment in construction firms is mostly made up of manual labour. They do not have extraneous clerical employment.

However, Australia's workforce is heavily tilted toward white collar management and clerical labour. If we assume that employment is lost across the board evenly (and I believe it will be heavily weighted towards white collar labour) then there won't be enough positions in construction firms for white collar workers.

The equation is as simple as that. You cannot supplement a fall in tertiary sector output by boosting secondary sector output. There has to be a better solution than just building roads.

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